Coach: Intriguing, but Not Yet a Buy

Coach (COH) is an intriguing company. It has a very strong management team, a rock-solid business franchise and favorable long-term outlook, yet it sells at a reasonable valuation.

Its stock lagged the market in 2012, declining 9% despite growing earnings. It has many of the attributes we look for and like, but it also presents some significant near-term issues, both macro and company-specific, that lead us to recommend waiting and watching.

The consumer spending ripple effect from the uncertainty posed by the fiscal cliff is a big concern, as exemplified by sluggish spending during the holiday season. Consumers, in particular higher-end consumers, seem to have been hesitant to spend, because of uncertainty concerning the full spectrum of tax exposure: tax rates, vulnerability to the Alternative Minimum Tax, dividends, capital gains, etc.

Although the fiscal cliff has been averted, another reason to wait on Coach is that there might be some short-term spillover impact on consumer behavior. Many consumers are likely to question the rationale for buying $300 to $500 leather handbags and wallets in the face of the uncertainty and lack of confidence that issues such as the fiscal cliff evince.

In addition, although taxes did not go up in a draconian manner, they did increase for higher-income families, and the Social Security tax increase on the first $113,700 of earnings will leave less money in consumers' pockets. Also, the 3.8% health care tax on investment income and capital gains might make people feel less wealthy. While we are confident that the U.S. economy will get through this situation, it might cause a temporary slowdown in spending on luxury items.

There are also more fundamental reasons to hang back. The company probably had a difficult Christmas season. It also appears that Michael Kors (KORS) is discounting some products significantly in order to move unsold merchandise, and this is likely to hurt Coach in the short term.

While these issues should work themselves out during 2013, we do believe there could be shorter-term stock price pressure. We could see a sub-$50 share price, compared with the current area of around $55. A mid to higher $40s share price could make Coach an attractive investment opportunity, offering a great point of entry and the likelihood of comforting clarity as 2013 unfolds.

Having expressed our reservations, we reiterate our admiration for the company, especially its strong business franchise, continued growth opportunities and attractive valuation level. Importantly, Coach is a manufacturer as well as a retailer. The result has been consistent 75% gross margins and a 35%-plus return on equity.

The company continues to gain global market share. Management and most analysts believe that earnings can grow double digits for another five years with continued North American store growth, a growing Asian presence, particularly in China, and a growing men's leather goods product line. Lastly, Coach's valuation level at 12x to 13x next year's earnings would be at the bottom end of its historical valuation level of 17x to 20x earnings.

Coach's franchise also has less overall risk than most consumer retail businesses. Coach owns its brand and controls all new product introductions -- this is critical. In addition, customers have high brand loyalty to Coach products, and this has resulted in a large number of repeat customers.

Lastly, customers have not shifted their purchasing decisions toward Internet retailing when buying luxury leather handbags and wallets, a practice which has compressed margins for many firms. Customers seem to prefer to touch and see the products in person before making an expensive fashion luxury purchase, and therefore they continue to visit and purchase products at the store. In addition, if purchases ultimately migrate toward the Internet, Coach would most likely still be the go-to product to buy.

Finally, management and Coach's board have a very shareholder-oriented mindset. Virtually all free cash flow of $700 million to $800 million per year, amounting to 5% of Coach's capitalization, is projected to be returned to shareholders through stock repurchases and dividends. The company can afford to do this because it has a net cash surplus of nearly $1 billion.

We believe that Coach will be worth the wait. The patient investor is likely to do quite well buying the stock, eventually.